September Agency MBS Update

Monthly Commentary

Agency MBS relative performance was positive in September as the late summer
malaise that took the agency MBS basis wider in August reversed itself to close
the third quarter on a high note. After a late August downturn in emerging market
assets caused volatility to tick up and the agency MBS basis to widen out the story
was reversed in September. Risk assets were far less jittery in September as investors
shook off fears of contagion and sent stocks rallying once again. Strength in U.S.
economic data further bolstered agency MBS relative valuations, with lower volatility
further buoying performance. Mortgage rates rose throughout September to 4.97%,
their highest levels since 2011. Higher U.S. Treasury and mortgage rates continue to
keep prepayment risk muted, with index extension benefitting lower duration assets.
The positive economic data caused the Federal Reserve to hike interest rates once
again late in the month as the Fed continues to normalize monetary policy. The
word “accommodative” was finally removed from the Fed’s press release, another
ceremonial step in the winding down of the most expansive monetary experiment
in history. Ultimately, the generally quiet month of news was conducive
to outperformance by agency MBS. Lower volatility and the specter of modestly higher
interest rates sent agency MBS relative performance into positive territory for the
month. In total, the Bloomberg Barclays MBS Index returned 11 basis points (bps)
in September, bringing year to date excess returns to negative 7bps. Absolute returns
continue to struggle, with year to date total returns at negative 1.07%.

Positive performance permeated the coupon stack in September, with higher coupons
outperforming their lower coupon counterparts. FNCL 4.5s posted excess returns
of 24bps in September, while FNCL 3.5s came in up 7bps. Mortgage rates that ticked
up were particularly beneficial for higher coupon collateral in September. FNCL 4s and
4.5s continue to benefit from increasing production after years of elevated prepays and
high dollar prices that have hindered performance. Lower coupons also outperformed benchmark U.S. Treasuries despite higher rates, as the rising
tide of agency MBS performance kept all coupons in positive
territory. Ginnie Mae collateral also posted strong relative
returns; Ginnie Mae 30yr (G2SF) 4s and 4.5s came
in at 16bps and 24bps of positive performance respectively.
The lower credit quality of Ginnie Mae collateral limits
extension risk under elevated interest rate scenarios, which
buoyed the collateral in September. Across all agency MBS
coupons, one of the biggest stories is the diminishing
attractiveness of TBA roll implied financing rates. When
the Federal Reserve started buying TBA and taking delivery
of pools, the result was all the worst-to-deliver bonds ended
up on the Federal Reserve’s balance sheet. This made TBA
rolls very attractive for most agency MBS investors who could
own TBA without the downside of fast paying pools being
delivered. With the Fed very close to ceasing agency MBS
purchases altogether, the worst-to-deliver bonds are returning
to the float for the first time in many years. One likely impact
of this factor is TBA roll levels may diminish over time. Lower
TBA roll drops could negatively impact coupons across
the agency MBS coupon stack, particularly where the TBA
deliverable has been dependent on Federal Reserve action
for positive performance.

The most pervasive topic in regulatory circles remains
the push to get Single Security orchestrated and implemented
by June of next year. While the basics of the FHFA’s directive
to make Fannie Mae and Freddie Mac bonds deliverable into
one single TBA have been known for some time, the FHFA
is now scrambling to get all of their loose ends tied up in time
to go live with the plan in June of 2019. Initial steps were taken
to allay one of the market’s largest concerns in September. An
initial rule was proposed to force Fannie Mae and Freddie Mac
to align prepayment speeds associated with each cohort, as
well as many other business practices. The rules are intended
to make it exceedingly difficult for one agency to compete in
any financial manner with the other, with the FHFA monitoring
prepayment speeds and regulating guarantee fees. In theory,
the rules will make it easier for the market to digest Single
Security. Investors will have codified language keeping the
two GSEs business practices aligned with each other. Yet
in practice, it is far from clear that having two entities that
previously existed to rival one another no longer be allowed
to engage in financial competition is in the best interest of
homeowners across the nation. That being said,
the destination of Single Security remains foremost on
the mind of regulators, and at the moment they are the
ones getting to drive the train to their preferred destination.

The end of the third quarter offers an opportunity to reflect
on the year to date for agency MBS. Relative performance
has been in negative territory throughout the year, and total
returns have struggled due to shifting interest rates. The 10yr
U.S. Treasuries closed back above 3% at the end of September,
coming from under 2.5% at the beginning of the year. The
first quarter of 2018 was where most of the damage was done
to relative valuations; historically low volatility from the latter
stages of 2017 was undone by higher rates and flurry of global
market concern. While volatility faded in the second and third
quarters of the year, the agency MBS basis rallied back. With
the third quarter of 2018 now in the rear view mirror, four of
the last five quarters have been characterized by exceptionally
low volatility. Does this new, more repressed level represent
a new status quo for interest rate volatility? Or should
investors look to other periods to determine the most likely
course of volatility going forward? While either answer
is plausible, we generally subscribe to the latter view. While it is
impossible to know when volatility will revert toward historically
higher levels, it is likely that agency MBS investors will confront
an environment of increasing volatility going forward.